Is It a New Dawn for the Bond Market?

China’s latest rate hike and a break of a major technical level could mean we're on the cusp of a whole new era for bond investors and traders.

Most members of the financial community were expecting the People's Bank of
China to again raise rates, and probably the only surprise was that the decision
came before the Chinese stock market reopened after the lunar New Year. As
demonstrated by their two previous rate hikes, the Chinese are very concerned
about inflation. The initial reaction of the Asian stock markets was negative,
especially in Hong Kong, but so far, the US and euro zone markets have shown
little reaction. Is the Chinese rate hike significant for our markets?

Figure 1

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This was going to be a pivotal week in the bond markets even before China's
rate hike. Last week, the long-term downtrend in 30-year Treasury yields (line
a) was broken. Yields are higher again this week, and a close above the
early-April peak at 4.86% will start a new uptrend as the chart will have formed
higher highs and higher lows. If yields rise as much as they did from the 2008
lows to the 2010 highs, the Fibonacci equality projection is for the 30-year
yields to rise to 5.83%.

Figure 2

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The weekly chart of the ten-year note yield gives us a better idea of where
US yields were when the Chinese cut rates and what happened afterwards. Though
there are not enough data points to draw any conclusions, the rate hikes in
China did coincide with some of the turning points in the US. For example,
during the week ending December 8, 2008, yields ranged between 2.76% and 2.54 %,
closing at 2.59%. Yields declined the following week to a low of 2.04% before
starting a 16-month rally back to a high of 4.01% in April 2010.

What About the Most Recent Rate Hikes?

The yield on the ten-year note bottomed at 2.33% on October 8, 2010, and it
was at 2.48% on October 19 when the People's Bank of China raised rates. Yields
have been rising quite sharply since, but paused briefly before the December 27
rate increase. The three-year resistance at 3.72%, line b, is now being
challenged. If the current rally in yields is of the same magnitude as the
2008-to-early-2010 rally, then the equality target for ten-year yields is at
4.13%. This is not far from the multi-year downtrend (line a), which is
currently at 4.20%. Therefore, it is possible that the long-term downtrend on
the ten-year yield will not be broken on this current rally, so rates could have
several swings this year. The chart has further resistance in the 4.50%
area.

Figure 3

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The quarterly chart of the T-bond futures (using a continuous contract) shows
how incredible the rally in bonds and the decline in yields has been from the
1981 and 1984 lows. This major trend line is currently at 110 with the parallel
uptrend from the 1994 lows just a bit higher at 113.50. (The futures actually
trade in 32nds.)

Figure 4

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The weekly chart of the T-bond futures formed a "gravestone doji" at the end
of August (see chart), which is quite a negative candle formation. As I
commented at the time (see Are Bonds Finally Topping Out?), this is a candle formation
often seen at major tops as the market moves high enough to entice the last
buyers before trapping them in at that high price.

The T-bonds declined into mid September and then rebounded into early
October, peaking at 135.34, well below the prior peak at 136.84. The weekly
on-balance volume (OBV) did not form any divergences at the highs, while some of
the other momentum studies, like the MACD-Histogram, did. The weighted moving
average (WMA) of the OBV started to roll over in late October, and the uptrend,
line c, was broken the week ending November 6, 2010. Capital started moving out
of the bond market over the next two weeks, which was in contrast to the massive
inflows into bond funds of the past few years.

NEXT: Higher Rates Present Exciting ETF Trading Opportunities

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Higher Rates Create ETF Trading Opportunities

Figure 5

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The iShares Barclays 7-10 Yr Treasury Bond Fund (IEF) completed a nice head-and-shoulders top formation on
November 12 when the neckline (line a) was broken on a closing basis. This was
over four weeks after the Chinese rate hike. There was a brief bounce from
support at $96.50, which was a good chance to get out, as the next wave of
selling was heavier. The daily OBV formed a negative divergence at the highs,
line d, as it failed to make new highs. No divergences were observed in the
weekly OBV. In December and early January, IEF formed a classic continuation
pattern (noted in red) that set the stage for the recent plunge as it dropped
from $93.70 to the $91 level in a matter of days. Prices are now reaching the
former downtrend, line b, and there is long-term support at $89. The daily OBV
shows no signs yet of bottoming, so any rebound due to the high bearish
sentiment is likely to fail.

Figure 6

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The iShares Barclays 20+ Yr Treasury Bond Fund (TLT) has not fared any better. The weekly chart shows the same
gravestone doji at the end of August as it corrected from above $109 to below
$101. The rebound into early October just retraced 61.8% of the decline, and the
sharply lower close the week of October 12 (see arrow) gave a strong sell
signal. The weekly on-balance volume dropped below its WMA in September and
failed to move back above it in early October. As I have mentioned in earlier
articles, this is a very negative development. The uptrend in the OBV was not
broken until November, and it has continued to make new lows. There is
multi-year support in the $85 area, but it may not be tested for some time since
the daily studies are oversold.

Selling the TIPS and Buying Junk

Figure 7

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Given the sharp decline in the Treasury Inflation Protected Securities (TIPS)
ETFs, like the iShares Barclays TIP Bond Fund (TIP), investors are either not worried about inflation, or
more likely, they're unhappy with the current low yield of 2.47%. The weekly
support at $105.40 (line a) could be broken this week, putting anyone who bought
this fund since last May in the red. There is some support in the $104 area and
major support at $102.40, line b. The weekly OBV broke its uptrend soon after
the rate hike, so perhaps some investors were convinced that future inflation
was no longer a problem. The OBV recently rebounded to its weighted moving
average, but is now declining once more, which does favor a further decline.

On the other hand, the high yield (read "junk bond") ETFs, the
iShares iBoxx High Yld Corporate Bond Fund (HYG) in this case, remain in a shallow uptrend as investors
continue to like its current yield of 8.48%. The weekly technical studies are
positive with the OBV well above its highs. Nevertheless, the chart pattern
makes me nervous. I would not be surprised if one sharply lower weekly close
completed a significant top. HYG had a wide range on Wednesday (Feb. 9) and
closed sharply lower on heavy volume. This could be the start of a more serious
decline. There is short-term support at $91.30 and stronger support at $90.74. A
break below the weekly support at $88.32 would complete a top formation. Too bad
there isn't a short junk bond ETF because there may be an opportunity there.

Figure 8

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From a technical standpoint, the ProShares UltraShort 7-10 Year
Treasury ETF (PST) looks better than the ProShares
UltraShort 20+ Year Treasury ETF (TBT). The daily chart shows that PST just completed a nice
continuation pattern (lines a and b) last week as it gapped to the upside and
moved through its short-term downtrend. The 50% retracement resistance now
stands at $45.40 with the 61.8% resistance at $47.20. If the rally from the lows
at point 3 is equal to the rally from point 1 to 2, the 100% equality target is
at $48.20. The weekly technical studies are positive and have been since
November. This suggests that an important low may be in place. The daily OBV has
confirmed the recent breakout and is holding above support (line c) and it's
weighted moving average. I would buy PST on a pullback to the $42.90-$43.34 area
and place a protective stop at $41.36. If filled, I'd raise the stop to $42.90
on a move above $44.60 and sell half the position at $45.21 to lock in
profits.

It does appear that the most recent interest rate hike by the People's Bank
of China coincides with an important turn in the US market; that being the
breaking of the long-term downtrend in 30-year bond yields. Since the T-bond
futures topped in August, I cannot say that their action is a leading indicator,
but more likely a confirming one. Over the next few months, we should get
further evidence to support the view that the 30-year bull market in bonds is
really over. If this trend has changed, it will require investors to adjust
their portfolios accordingly. Though stocks may initially react unfavorably to
rising rates, it should be bullish for the intermediate term. Traders should
also have many opportunities in an environment where rates are rising, rather
than falling.

Tom Aspray, professional trader and analyst, serves as senior editor for
MoneyShow.com. The views expressed here are his own.